Conquering the Steppes with Genghis Bonds

A frontier market, Mongolia, has unleashed its Genghis Bonds denominated in US dollars, that will help them conquer their steppes. Yet, the question is whether investors will be able to conquer their steppes too.

12th century Genghis Khan - Mongolia's most famous export

Mongolia transitioned from a one-party communist political system into a democratic system in the 1990s. The Economic Political Stability Index 2013 and Economic Freedom Index 2013 highlight that Mongolia, ranking 75^th out of 177 countries, fares above average in the world. Corruption is also down with Mongolia ranking 94^th out of 174 countries on the 2012 Corruption Perception Index. Yet there have been some political problems with the government in 2012 suspending South Gobi Sands mining licenses and then asking to renegotiate the Oyu Tolgoi investment agreement. Economically, Mongolia, bordering two monoliths - Russia and China, is the most sparsely populated country in the world with just 2.8 million people within a country boasting more than 6,000 known mineral deposits that could enable Mongolia to become a major determinant in global gold, copper, zinc, coal, oil, uranium and molybdenum markets. Since the 1990s, Mongolia’s economy has shifted from largely agriculture-driven to a reliance on the minerals industry. Mongolia also has one of the world’s fastest growing economies with real GDP growth averaging 13.5% annually over the next five years, comparing favourably with China’s at 8% and India’s at 7.6%. Yet due to an undiversified economy and inflationary monetary and fiscal policy, Moody’s have given Mongolia a speculative grade B1 credit rating. The mining boom has increased foreign direct investment into Mongolia from US$100 million in 2003 to US$6.1 billion in 2012 with the majority of those flows derived from China, Canada and the Netherlands. In addition, Mongolia possesses competitively priced raw materials, low operating costs for foreign companies, a low corporate tax rate, favourable tax credits and cheap labour culminating in a favourable investment environment. In fact, according to the World Bank’s 2012 Ease of Doing Business Rankings, Mongolia is ranked very similar to Italy and higher than China and Russia.

In November 2012, Mongolia sold US$1.5 billion in debt in its first government bond offering, equal to nearly one-fifth of its total economy. The US$500 million five-year bond yield was around 4.125% and the US$1 billion ten-year bond yield was around 5.125%. As a comparison, Spain, the Eurozone’s fourth largest economy had its ten-year bond yield at 5.3%. The November offering was ten times oversubscribed with US$15 billion in bids compared with the size of Mongolia’s total economy valued around US$10 billion. The bond issues by the Mongolian government aimed to raise finance for infrastructure to develop its booming mining industry. International investors seem desperate for incrementally greater yields, which has been the driver behind Mongolia’s low bond yields. The difficult search for high yield assets in the current economic climate has allowed Mongolia to obtain yields that are likely half of what they would have to offer investors under normal credit conditions. In addition, the fact that Mongolian debt is relatively rare also added to investor demand as investors sought to diversify their portfolios. In fact, relativity is another of the drivers behind Mongolia’s low yields – Genghis bonds look great compared to 2.5% for a 10-year Mexican bond and 1.6% for the US 10-year Treasury Bond.

Despite the risks, Genghis Bonds are proving a hit

Yet some investors caution buying Genghis Bonds at such low yields, arguing that such yields do not capture the risks inherent in a frontier economy with a history of political instability. Mongolia has asked for emergency loans from the International Monetary Fund five times in the past 22 years. Genghis Bond yields stumbled US$7 in December due to political instability when the fragile coalition government ordered cabinet ministers from the Democratic Party to leave, but they have since crept up again. Furthermore, Mongolia’s economy are currently having to deal with weaker global commodity prices as gold and energy prices in particular have dropped sharply. The problems creditors are having with Belize’s default over a US$544 million bond and with debt from Saint Kitts and Nevis highlight the dangers with frontier debt. Investors also have to beware of the volatile legal and regulatory environment in Mongolia as they draft new foreign investment rules pertinent to the mining sector.

I guess what has priced Genghis bond yields so close to Spanish bond yields is that investors are asking whether they would prefer the financial gains and political risk of Mongolia on the one hand or the risk of euro contagion of Spain on the other hand. Given the larger risks for a Spanish meltdown, it is no wonder that investors believe that Mongolia could just be able to service their debts better than Spain. Other investors worry that this is a bond bubble that will burst when the US Federal Reserve begins raising interest rates again – yet for now we are not close to the bursting point and Genghis bonds, denominated in USD, could be boosted if we are yet faced with further eurozone deterioration.

Investing in Myanmar’s Future: Myanmar Agribusiness Public Corporation (Mapco)

Investing in Mapco may be difficult given that Myanmar will not have a stock exchange until 2015, but it is certainly an inimitable investment – Mapco offers exposure to one of the most exciting frontier markets as well as tapping into the global growth in food demand. Shares in Mapco also come cheap at 10,000 kyats per share (roughly USD$11). An investment in Mapco in particular looks good for the long-term as it is a wholly publicly owned company with strong government links, strong future development, and its major product (rice) happens to be one of Myanmar’s trading comparative advantages.

Farming for the Future

Mapco have just announced two joint ventures with Japanese companies that have been encouraged by the Japanese government to assist in Myanmar’s desire to again become the world’s largest rice producer. The political will behind these joint ventures is evident as Japan has the world’s most protected rice industry and therefore their agreement to a 5,000 ton shipment of long-grain rice from Myanmar in February 2013, their first import of rice from Myanmar in 45 years, is unique. One of the joint ventures is between Mapco and Mitsui to establish the Integrated Rice Complex Project (IBCP), a network of rice-milling and processing plants in Myanmar that will supply countries along the West African Coast with around 400,000 tonnes of low-quality (25% broken) rice. Mapco’s second joint venture is with Mitsubishi to start milling tropical japonica rice – used to make thin rice cakes popular for consumption in Japan – at mills in Myanmar. Innovatively, Mapco plan to power the processing plans and mills using electricity from rice hulls. Korean Dawoo company have also signed a memorandum of understanding with Mapco to jointly implement a factory in late 2013. Vietnamese private equity firm Vina Capital see the opportunity with Mapco as they have provided an undisclosed investment to the firm. Furthermore, Mapco do not only seek to exploit rice products as they are focusing on finding companies to invest in within Myanmar that produce value-add agriculture products as well as infrastructure and transport.

It is evident from the amounts of rice that Mapco produce and export that they have a monopoly in Myanmar’s market. This potential plus their resources and technologically-adept foreign partners make Mapco a potent investment.

Key problems with rice production in Myanmar, and therefore a danger to Mapco’s profitability, are:

·         Problems of land ownership and land development – many farmers do not have the right to own and register their land, farmers do not know how to correct salty lands, and to utilize multi-crop patterns;

·         Poor knowledge and practices of farmers in land preparation, selection of traditionally collected seeds as opposed to higher yielding varieties and cultivation – most farmers use cattle and only very few are able to use ploughing machines;

·         High cost of inputs such as labour, seeds, machines, and fertilizer- agricultural labour is expensive because many people from the villages migrate to other urban sectors, machines and fertilizers are expensive because the majority are imported and therefore not easily accessible to the majority of farmers;

·         Poor development of local credit market – credit is in cash and not in terms of commodities, local credit markets place heavy burden on farmers;

·         Low price of rice that reduces earnings – price of rice is rather low compared to price of inputs, lower price of rice is seasonal, Myanmar government has introduced rice buying scheme to stabilise price of rice for farmers;

·         Poor coping mechanisms for problems such as local flooding, droughts, and untimely rains.

68% of Myanmar's land is arable

On the macroeconomic level, investing in Mapco taps into Myanmar’s comparative advantage in rice products. Agriculture is Myanmar’s main economic sector, contributing 34% of their GDP. Under British colonial rule, Myanmar had been the world’s largest exporters of rice. However decades of economic isolation diminished their exports and in 1962, coinciding with the military takeover, they were overtaken by Thailand. Since the opening up of Myanmar last year, this is changing and last year’s rice exports was the largest for 30 years. In 2012 Myanmar exported 2.1 million tons of rice in 2012. In addition, Myanmar’s agricultural sector has advantages over competitor producers Thailand or Vietnam due to extremely fertile lands and large quantities of idle land, abundant labour force, and a winning mix of strong rains and sun. And yet, Myanmar’s overall production of rice was 13.6 million tons compared to Vietnam’s total rice output being 44 million tons and Thailand’s 37 million tons. What this comparison shows is the amount that Myanmar’s main rice producer, Mapco, can potentially grow to dominate.

Throw in Myanmar’s strategic location between Asia’s two economic giants – China and India – and their projected growth rate for the next decade of 7-8% annually as well as their rich natural resources, and Mapco, held long-term, could be a masterstroke of an investment.

The Three Arrows of Abenomics

Japanese Prime Minister Shinzo Abe’s programme for his country’s economic recovery has led to a surge in domestic confidence. His comprehensive programme entails monetary, fiscal and structural policies – he has likened his programme to holding three arrows that taken alone, each can be bent, but taken together none can. Let’s examine just how successful his three arrows can be in facilitating a Japanese recovery.

The Abenomics Theory of Economic Recovery

Monetary policy involves controlling the supply of money, often through changing the key government interest rate in order to promote economic growth and stability, contain inflation, or ensure low unemployment. In the case of Abenomics, the target is to reverse Japan’s chronic deflation problem which has plagued the country for over a decade with a higher real debt burden for Japan’s US$13.64 trillion government debt (2^nd highest worldwide). Hence since the appointment of the new governor of the Bank of Japan, Haruhiko Kuroda, the BoJ have adopted an inflation target of 2%. They plan to achieve this target by doubling the BoJ’s holdings of bonds and stocks over the next two years as well as extending the average maturity of bonds it buys to about seven years from the current three years. Once their purchase programme has been completed, they would have bought an estimated 1.4% of their GDP in assets, which compares with the US Federal Reserve’s buying programme that targeted 0.6% of GDP. Additionally, the BoJ’s buying programme has sent the Japanese Yen to its lowest level in five years against the USD of 99. The weaker JPY has made Japanese goods more competitive and led to a surge in exports that has sent the Nikkei into a 70% upward rally. Yet, the need for three arrows in Abenomics is necessary as exports are only 15% of Japan’s economy, highlighting the need for structural changes to really make Japan’s economy more competitive.

The fiscal side is concerned with the use of government revenue collection from tax and government spending to influence the economy. Here Japan have passed a government budget for 2013 that cuts spending for the first time in 7 years in order to establish fiscal discipline. The government is eliminating tax subsidies to local governments, reducing spending on education, cutting salaries of civil servants, and expunging JPY910 billion in discretionary funds. However this budget does not include Abenomics’ US$116 billion fiscal stimulus package that is also tied to the third arrow of growth. The package seeks to invest in public infrastructure projects and subsidies for companies to invest in new technology and loans for SMEs in order to raise real economic growth by 2% and add 600,000 jobs to the economy. While the spending is supposed to focus on bringing growth through innovation investment, there are worries about possible growth in Japan’s government debt which is twice the size of its economy. There are also concerns about the last failed attempt to use fiscal stimulus in Japan during the late 1990s following the Asian Financial Crisis. Yet I contend that at the time there was a large decrease in the domestic credit supply which made it extremely difficult to successfully restore growth just using increased government spending and that the fiscal stimulus instituted provided a cushion for Japan’s economy, evidenced by unemployment being relatively low around 5.8% in the years after.

Shinzo Abe looking Confident

Structural policies aim to restructure the economy, improve productivity and encourage higher labour force participation. Here is where Abenomics will be most challenged. Japanese culture asserts domination of the male and this is where socio-cultural norms need to be altered to encourage higher female participation in the work force. Abe believes change starts at the top, hence why he is encouraging every major company to have at least one female board member. He is also attempting to increase workers’ wages by encouraging the private sector to do so. Yet here there is the need for the private sector to alter their conventions as there is little that Abe can do apart from set the tone. That said, Japan does well in many areas already. Although Japan has a shrinking labour force, its productivity is high with output per worker growing 3.07% year-on-year compared to the USA where output grew 0.39% year-on-year and Germany where it shrank 0.25%. In addition, Japan has one of the highest commitments to environmentally friendly policies – there is a reason why it’s called the Kyoto Treaty. And Japan has one of the lowest income inequalities, measured by the Gini co-efficient, than other developed countries. Despite the pluses, the biggest challenge is the need to find a solution to mitigate Japan’s population fall. There is a need to encourage families to have more children and to find innovative solutions to solve a burgeoning social welfare spending that has grown 10.5% this year as Japan prepares for 2014 when 25% of their population will be older than 65 (compared to 9.5% in China and 14% in USA) and living longer than ever with average life expectancy at 85 years.

The long-term success of Abenomics will depend on the strength of policies in all three arrows, which is the central tenet of Abenomics. Its success will herald investment opportunities in Japanese companies as a whole as well as trading in the Nikkei stock exchange index. However there are also opportunities to invest in certain areas:

·         Companies that show a shift in strategy towards greater exports and investments overseas;

·         Companies that are investing in new technology;

·         Companies that focus on social entrepreneurship around the elderly, healthcare and old people’s homes.

Booming Asian Healthcare: IHH Healthcare Berhad

Heard of Medical Tourism? Its a growing phenomena with an estimated 36% of all medical operations conducted on citizens outside their country of birth. Yes, some of this total will include those resident outside their country of birth, but a large component will be those actively seeking treatment in low-cost areas. One such area where medical tourism is hugely prevalent is South-East Asia. Buy into this trend now while it still remains low-key.

Thailand's top private hospital - Samitivej

The growth of the healthcare industry is not just about the medical tourism trend. It is also about the emerging middle-class that is able to afford better healthcare, not just as a necessity but also to improve their quality of life and for cosmetic vanity. Furthermore, with aging populations in some parts of Asia, healthcare focused on the elderly is a factor. Populations are growing extremely fast in most of Asia, which is a boon for the industry and there is a changing disease profile in Asia which will require greater investment in the healthcare industry. Not only has healthcare expenditure in most countries globally doubled in the past decade, the room for growth in developing countries is much greater as average spending per capita is a fraction of that in developed nations. Malaysia spent US$368 per capita on healthcare last year compared to US$4775 in Australia.

With such a strong potential growth trend combined with the non-cyclical characteristic of the healthcare industry, investors should look for private healthcare providers that already have a well-established brand and efficient management. These are the companies that will benefit from the continued development of healthcare in Asia over the next 30 years. The major threat to any company in this sector is spiralling cost and therefore effective management is necessary to control costs in order to maintain profitability in a sector that is burdened with costly technological innovations and manpower shortages. Furthermore, private companies with good networks of partnerships across borders will benefit from cross-referrals and easier market penetration – the value-add for an investor.

Will they find the cure for the next H8N9 bird flu?

One company on my radar is IHH Healthcare Bhd - a listed company on Malaysia’s stock exchange, the Bursa Malays, since last year. Its share price currently trades at MYR3.660 and increased 32% from last June. IHH Healthcare is one of the world’s largest listed healthcare providers with healthcare operations in Singapore, Malaysia, Turkey, China, India, Hong Kong, Vietnam, Brunei and Macedonia. This is a company with diversified geographic exposure and with an integrated healthcare network consisting of 4,900 licensed beds in 30 hospitals and 60 medical centres. It also has a great future evidenced by three hospitals opening in Malaysia in 2013, one in India, one in Vietnam, and one in Shanghai in 2014. IHH also won a US$645 million contract to build Hong Kong’s first private hospital, slated to open in 2016. In addition, they founded Malaysia’s first private healthcare university, IMU, to offer local and foreign medical, dental, pharmacy, nursing and health science programmes. If I were you, I would buy IHH now at its current share price of MYR3.660 and hold long-term for very strong gains, both from the currency exposure as the MYR gets stronger and from the capital appreciation.  

The Chinese Wear Prada

Luxury goods are positional or Veblen goods. The more expensive they are, the more people want them. One such brand that is taking advantage of its Veblen goods is Milan-based Prada. Prada is also seen as a proxy for the booming luxury goods market in Asia, especially China. With a market value of US$26 billion and one-third of global sales coming from East Asia excluding Japan, my bet is that the Chinese will continue to wear Prada. Prada shares, listed on the Hong Kong stock exchange, nearly doubled in 2012 and are currently hovering around HK$72.70. Yet investing in Prada is not just about its excellent exposure to Chinese demand for luxury goods; it is also about the broader luxury goods industry trends that an investor can tap into.

Luxury goods sector

Luxury goods can be divided into ‘hard luxury’ describing products such as watches, jewellery and pens, and ‘soft luxury’ describing handbags, wallets, and shoes. Whilst watches and jewellery are often considered together, their distribution structures are actually quite diverse. Watches are primarily wholesale-driven, because consumers want to compare designs, brands, prices and functionality. Jewellery is often retail-driven – companies sell their own jewellery in their own stores. As a whole, the luxury goods sector is characterised by high operating margins, substantial emerging market exposure and strong cash generation. China’s rapid wealth creation, currently with 3 million people holding assets worth 10 million yuan (roughly £1 million) and projected to treble by 2016, means its accounts for about 60% of all growth in luxury goods sales worldwide. Indeed, China recently overtook the USA as the country with the highest demand for branded luxury watches. Yet, there is a worry that as China’s economic growth rate slows, the luxury industry’s growth will also follow. In fact, some analysts are worried that the luxury goods market may experience a bubble, yet I contend that these luxury goods are less prone to bubbles (than property) given their customer base and the fact that the equity of many luxury goods brands are tightly controlled by founding families who take a long-term approach to running their companies.

In the last two years, luxury goods sales have soared by 30% and the shares of their producing companies, such as Prada, have followed suit. One thing for investors to bear in mind is that as a momentum sector, multiples expand when earnings estimates are raised, and vice versa. Luxury goods companies tend to trade on forward-looking price/earnings ratios due to their businesses not being very capital or debt-intensive. Therefore, historically the luxury sector has traded at a 50% premium to the market. Yet there are several determinants that may affect the demand for luxury goods:

1.      Investors need to analyze high-end consumer behaviour, which differs from the rational average income consumer – luxury goods demand is considered to be directly linked to GDP growth. Yet, this may not always be the case as demonstrated by the growth in luxury demand in Japan during their recession in early 2000s as well as growth in luxury demand in Western Europe in 2010 and 2011 despite decreasing consumer confidence.

2.      Concept of trading up or trading down – With luxury goods, high-end consumers tend not to trade down when times are tough as they would rather postpone buying a Breitling watch than trade down to a Swatch.

3.      Growth of counterfeit luxury products – larger amount of counterfeit luxury products of a certain brand, the less demand there is for the brand from high-end consumers. Hence the tight control exhibited by many of the luxury brands.

4.      Pricing power – luxury brands do not compete on price but on design and desirability (related to difficulty of acquisition). Luxury brands therefore are able to maintain their prices despite economic downturns, and during recovery phases they tend to launch higher-priced and higher-margin products as well as raise prices.

One of the trends opening up a new market for luxury brands to exploit is the move by companies specializing in ‘soft luxury goods’ into ‘hard’ luxury by launching jewellery and watch collections. Louis Vuitton, Salvatore Ferragamo, Versace, Bottega Veneta, Hermes, Ralph Lauren, Chanel, Gucci, Prada, and Dior are all moving into this market due to the enormous opportunities. The jewellery market worldwide is worth approximately US$150 billion. Furthermore, jewellery with a brand name attached to it currently represents just 18% of this market (compared to branded leather goods representing 50% of their market and branded sunglasses and glasses representing 38% of their market). These luxury brands are seeking to capture a fraction of that market share to open up a new market in a potentially high-growth area.  

Prada store in Chongqing

Prada are well-positioned to continue capturing market share in the Asia-Pacific region. Their profit in 2012 was US$805 million, a 45% increase from 2011. Moreover, despite the crackdown on corruption and ostentatious gifts in China at the end of 2012, Prada have managed to maintain strong growth in profitability. Prada’s performance and reasons for continued growth in their share price are:

·         Prada regularly unveils new collections in order to remain in vogue and to avoid brand weariness among consumers;

·         Prada has just started its expansion into emerging markets in Asia, the Middle-East and South America, as opposed to its competitors Gucci and Louis Vuitton – meaning there is ample room for growth of its brand;

·         Having just started expanding in Asia whilst maintaining higher price points for products, despite lower average incomes for local consumers, Prada are well-placed to experience continued sales growth. This is stark contrast to Burberry who came into China with a democratic luxury sales strategy which entailed adjusting product prices for the local market – this has blown up in their face during the economic downturn. In addition, Burberry derives the majority of its sales from its apparel business – more sensitive to slowdown in spending than Prada’s sales from leather goods;

·         Prada have retained their core strength in the European market by recording 54% sales growth in 2012 despite the economic downturn – other brands such as Burberry have not been able to do this;

·         Prada’s focus on leather goods is proving profitable – leather goods sales increased 47% last year, providing 64% of Prada’s sales. During a downturn, consumers look to leather products more as they see them as more durable and a better store of value;

·         Prada’s less-intrusive logos keep its brand’s cache strong, as does its higher price points for its products. Some brands’ logos, such as Louis Vuitton, have become too ubiquitous in Asia;

·         Prada is more family-owned than other brands, such as Burberry, with 80% of the company’s equity held by the Prada family and other senior executives – this means Prada’s management and shareholders will be taking a longer-term approach in their growth strategy.

Luxury goods stocks historically have shown strong growth, trading at a premium valuation to the market. The key concern is the sustainability of their growth, and the key question for Prada is how close the brand is to being mature. Prada still has millions of potential customers to satisfy in Asia and their fast-innovation should ensure that the Chinese continue to wear Prada. I would wait for Prada shares to decrease slightly to around HK$60 before buying to sell at around HK$90 by October this year.

 

Chesa-peake Too Far

The controversial shale gas extraction

The major energy development of the past five years has been the development of unconventional oil and gas in the USA – known as shale gas and tight oil. One company that was at the forefront of the exploration and development of these unconventional energy assets was Chesapeake Energy. Yet in its rapid expansion to become the USA’s second largest natural gas producer, Chesapeake may have tried to climb one too many mountains too quickly. This looks like a company ripe for shortselling activity.    

Chesapeake reported an 87% drop in its earnings in 2012 from US$1.94 billion to US$285 million, due to rising oil production failing to compensate fully for the rapid fall in the price of natural gas as a result of the huge supplies of shale gas uncovered by firms such as Chesapeake in the USA. In fact, the large decrease in the price of natural gas forced Chesapeake to writedown US$2 billion of the value of their oil and gas reserves last year. In addition, the company has net debts of US$12.3 billion. They also entered into structured finance transactions called “volumetric production payments” which committed them to pay future flows of oil and gas in return for upfront cash payments, which has been a bust on the company’s balance sheet. To further exacerbate their financial woes (if possible), Chesapeake made the decision not to hedge against the large decrease in the price of natural gas, which dented natural gas sales revenues in 2012.  

The terrible financial state of the company is prompting Chesapeake to sell its one great competitive advantage – its oil and gas fields. The company made US$12 billion in disposals last year and plan US$7 billion in disposals in 2013. Chesapeake are attempting to find buyers for oil and gas fields in the Mississippi Lime region of Oklahoma and Kansas as well as the attractive Marcellus play in Pennsylvania. Chesapeake also plans to reduce its spending on drilling and completing wells from US$8.8 billion in 2012 to US$6 billion this year.

Chesapeake won't climb this mountain

In order to combat Chesapeake’s problems, they have pushed to increase production of more lucrative tight oil rather than gas. Yet oil production still accounted for only 15% of total production with 85% coming from dry gas and natural gas liquids. Whatever is left of Chesapeake in the future isn’t worth investing. The founder, Aubrey McClendon, was forced out as CEO by activist shareholder Carl Icahn. The extreme reduction in capital expenditure over the past few years ensures that Chesapeake have less production and cash flow to build a profitable future. Furthermore, the new natural gas market brought about by the advent of shale gas provides the challenge of low prices that require deep pockets to circumvent – only international oil companies such as Exxon Mobil, Chevron, BP, Shell, and independent companies without a build-up of debt can afford this new environment. Chesapeake is not of them. I would therefore recommend shortselling Chesapeake’s share price, currently at US$18.47 per share to reach a target of US$14 by the end of June.

Simultaneously buying Range Resources Corporation stock, another company with large holdings in the attractive Marcellus play (1.1 million acres), would be a fortuitous investment. Range Resources has developed a low cost structure and strong balance sheet over the past five years, which has coincided with a 41.3% increase in share price. Range Resources’ share price currently sits at US$71.78, which should be bought with a target of US$83 in mind to sell at by the end of June. Moreover, for a company with market capitalization of US$11.45 billion, it has ensured a low amount of debt of US$1.79 billion. Their financial results in the past two years have been record-breaking, with proven reserves and production both growing by 13%. If natural gas prices increase from the current nadir of around US$3-4, watch this stock price soar.

 

Russian Rubble?

It may be twenty five years since perestroika and glasnost lifted the Russian rouble from rubble but the RUB has still had to rely on hard intervention at times. This is changing with the Central Bank of Russia (CBR) and their new governess Elvira Nabiullina – the first female to head a G8 Central Bank.

The Kremlin's steadier foundations

Central Bank of Russia’s recent monetary policy decision to move towards a free floating exchange rate, liberalization of the interest rate market as well as inflation targeting bode well for the RUB. Governess Nabiullina aims to promote economic growth whilst reducing inflation to around 3-4%. Her appointment should be seen as a step towards easing of Russia’s monetary policy. Additionally, she is Putin’s strong ally and therefore has the power base to push through easing policies. Nabiullina previously served as President Putin’s economic advisor as well as Minister of Economic Development and Trade. She was one of only six senior government officials to follow Putin back from government to the Kremlin administration after his 2012 election victory. Following her appointment, the CBR may cut interest rates in the coming months as growth has slowed to around 2.1% year-on-year from 3% in Q3 2012.

Since July 2012, the RUB has traded close to its midpoint of 35.15 against a basket of currencies. Global factors have been more essential determinants for the RUB than domestic data and events. One of the major global factors is the oil price as Russia is the largest exporter of natural gas, the price of which is linked to oil. Nervousness will remain high due to the Cyprus mini-crisis. However the RUB has moved bearishly over the last few months suggesting that these risks are already priced in. Until the end of 2013, other factors will be important for the RUB:

·         Russia has comparatively strong economic growth, which is RUB supportive;

·         However its strong domestic demand has attracted increased imports which means its current account surplus is on a downward trend. Yet there is still likely to be a surplus (RUB neutral);

RUB Movements

·         Capital outflows remain strong but are likely to moderate as political risks associated with last year’s elections dissipate and global growth improves (RUB supportive);

·         FX reserves are relatively stable at USD$532 billion;

·         Net FDI flow will likely change from negative to positive as investors seek to invest more money in Russia, in particular due to the new access to the Russian government bond market as well as the relative attractiveness of equity in Russian companies. The MICEX tracks the performance of the 30 largest and most liquid Russian companies from 10 main economy sectors that are listed on the Moscow Stock Exchange – it has grown by 1500 points from 1998 to 1586 (RUB positive);

·         Carry trades involving RUB are likely to be in vogue due to Russia’s short-term interest rates of 8.25% being one of the highest among large countries (RUB positive).

Overall I expect the RUB to gain about 5% by the end of 2013 from around 35 to 33.5 against the basket of currencies. In addition, it is important to bear in mind the strength and determinants of Russia’s economy. The Russian economy is the fifth largest in the world and is commodity-driven. Russia is the world’s largest producer of oil (12% of world output), natural gas (18%), and nickel (20%). The energy sector contributes 20-25% of GDP, 65% of total exports and 30% of government budget revenue. In Russia, services are the biggest sector of the economy and account for 58% of GDP. Within services the most important segments are wholesale and retail trade, repair of motor vehicles and motorcycles, and personal and household goods, public administration, health and education, real estate, transport and storage. Industry contributes 40% of total output – mining (11% of GDP), manufacturing (13%), and construction (4%). Agriculture accounts for the remaining 2%. During the past decade, poverty and unemployment (5.8% in February 2013) have steadily declined along with expansion of the middle class. Similarly, from 1991 until 2013, the Russian inflation rate averaged 155%, yet it is now currently 7.2%. Russian government debt to GDP was also 9.6% in 2012, a marked decrease from a high of 99% in December 1999. The easing of government control on the economy under Nabiullina along with the Russian economy’s strong fundamentals are positive for the RUB. Therefore, the Russian rouble is far from rubble.